DP10560 Government Guarantees and Financial Stability
|Author(s):||Franklin Allen, Elena Carletti, Itay Goldstein, Agnese Leonello|
|Publication Date:||April 2015|
|Keyword(s):||bank moral hazard, fundamental runs, government guarantees, panic runs|
|Programme Areas:||Financial Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=10560|
Government guarantees to financial institutions are intended to reduce the likelihood of runs and bank failures, but are also usually associated with distortions in banks? risk taking decisions. We build a model to analyze these trade-offs based on the global-games literature and its application to bank runs. We derive several results, some of which against common wisdom. First, guarantees reduce the probability of a run, taking as given the amount of bank risk taking, but lead banks to take more risk, which in turn might lead to an increase in the probability of a run. Second, guarantees against fundamental-based failures and panic-based runs may lead to more efficiency than guarantees against panic-based runs alone. Finally, there are cases where following the introduction of guarantees banks take less risk than would be optimal.